Why are junior mining stocks in the investment dog house...?
Now we want to provide the rationale behind mining equity investment, how to choose between metals futures or metals miners, and conclude with which mining sectors looks strong from here.
Gold Miners: The Rationale
The key to investing in mining equity is leverage. Suppose a copper miner's break-even point is 70 cents a pound. The company wouldn't have been worth much when copper was 70 cents as it couldn't turn a profit.
At a $1.00 copper price, however, the company will make 30 cents per pound of copper produced. And at $4.00 copper, its earnings will go up eleven times over to $3.30 cash earnings per pound.
So the theory is that if copper prices go up 4-fold, copper mining stocks would go up 11-fold. In fact, this is pretty much what has happened since 2002.
As copper went from 70 cents to $4.00, giant copper miners such as BHP Billiton went from $8 to $90.
If BHP's case were universal to miners, would all investors jump on the mining bandwagon to take advantage of booming commodity prices?
Only if the case is so clear cut; indeed, if we look at Oil and Gold mining equities, a different picture emerges.
Crude went from $22 per barrel post-Iraq War to now over $130 per barrel. Yet Exxon Mobil has merely doubled from $40 to $80.
Gold went from $250 per ounce in 2001 to $970 per oz today. Yet Barrick, the world's largest gold miner, has merely tripled from $15 to $45.
So why have gold miners and oil companies underperformed relative to gold and oil respectively? We can only speculate that:
- Equities seldom trade at fair value: investing would be easy if all companies were to trade at fair value. The sentiment pendulum swings to from fear to greed;
- Equity investors are different from commodities futures investors. Mining investors seek earnings, while commodity investors are speculating on future prices;
- Gold mining companies have "optionality value", which means their resource of gold in the ground yet to be mined. Such a concept is foreign to many earnings-focused money managers;
- Mining is a risky business: accidents, nationalization, appropriation, labor strikes, tectonic movements and cost overruns are common;
- Rock or Jewel? Metals prices are volatile, and stock valuations are forward-looking. What future metal price does an analyst use to forecast the future earnings of a miner?
- Mining is a burning stick: Miners need to constantly develop and acquire new reserves and properties. It is a costly and lengthy process to develop new deposits, which makes a valuation so much tougher to assign.
The point here is that the success of BHP, while not unique, is not the standard throughout the entire mining universe.
Gold Miners: Junior Mining in the Dog House
If one looks for the speculative extreme in mining equities – the junior mining sector – a dire case could be made against investing in mining. Because the sector has utterly failed to live up to the expectations of investors.
Junior resource equities are supposed to provide greater leverage than major mining producers. However, the nature of the business requires a constant injection of capital to discover and develop deposits before the eventual handsome operating cash-flow is realized.
This model is vulnerable to sudden and occasional credit/liquidity crunches like the one we're experiencing now. It's signal that the top in the Toronto Stock Exchange Ventures Index – a proxy to junior stocks – topped in mid-2007, merely doubling from the bottom of 1,000 to trade at 2,300.
Right now, cash is king. And in these uncertain times, we like cash in Gold.
The US government-sponsored mortgage lenders Freddie Mac and Fannie Mae are on life support, provided by the Federal Reserve Bank of New York. All together, the GSEs back $5 trillion of low yield (5%-7%) assets. You have to wonder what the global asset managers holding those debts are going to do.
Real estate is cooling off worldwide now, from Singapore and Thailand to Vancouver. I am not seeing a crash, nor do I think that housing will crash. But the Asians are running in a mad panic over inflation and yet we have interest rates at 2-3% from Hong Kong to Singapore, Thailand to Japan, Korea to Taiwan.
On top of that, we have global equity indices rotting with most down by double-digit percentages. Some, such as Vietnam's stock market, are down some 70% this year.
The point is there's nothing stronger to invest in at the moment than Gold. We are now seeing a nice gold run as interest rates begin to trend up.
Of course, this overview is by no means exhaustive. But the Barrick and junior resource camp may be glad to know 10-bagger success does happen to miners, as BHP demonstrated. The BHP camp might take caution in that mining isn't all risk-free glorious business.
We didn't have the foresight to put all our money in BHP, and instead we focused on juniors exploring for Gold in exotic locations such as Africa. Being a Feng Shui student, I learn that every dog has its day, and perhaps finally it's time for the past dogs of Barrick and other gold miners to shine?